Health care boards can face criminal and civil liabilities.
Health care corporations are not immune from executive mismanagement as is evidenced from the recent trial of HealthSouth's former CEO. Richard Scrushy was the first chief executive to face charges of violating the 2002 Sarbanes-Oxley Act that requires top officials to vouch for the accuracy of financial statements. In June of 2005, he was acquitted on multiple counts of fraud and money-laundering charges in the $2.7 billion accounting fraud at HealthSouth.
With these cases in mind, let's look at the fiduciary duties, civil and criminal liability of a board.
The primary duty of directors is one of a fiduciary nature. What does it mean to be a fiduciary?
Fiduciary relationships involve duties of trust and confidence. Many courts and legal commentators hold that both corporate directors and officers owe fiduciary duties to equity shareholders. The duties of trust and confidence are often spoken of as the duty of care. This is to be distinguished from the duty of loyalty that involves conflicts of interest.
The elements of duty of care are good faith and reasonableness. Good faith involves honesty, no conflict of interest, and not approving illegal activity.
Reasonableness involves a belief that a board decision must be to further corporate interests. In addition, reasonableness applies to the procedure of decision making and oversight. For example, a board does not act reasonably when directors make decisions without adequate study and deliberation.
If a board decision breaches duty of care, all board members present who voted or failed to object may be held jointly liable for damages resulting from the decision. There are slight variations depending on state statutes. In fact, some states have exculpation statutes that shield directors from personal liability for breaching a duty of care. (1)
In addition to personal liability of directors, a court of equity may enjoin the transaction in question. The Caremark decision continues to haunt the health care boardrooms, leaving directors questioning their degree of personal liability for business decisions. In 1994, a federal grand jury indicted the corporation, two officers, and employee and a physician for anti-kickback violations. (2)
The board approved a settlement agreement with various government agencies and private insurers totaling more than $350 million. A shareholder derivative suit followed. Director duty of care violations in failing to monitor corporate performance are "the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment." (3) The result of the litigation is that corporate boards may face liability for failure to implement a reasonable gathering and reporting system.
In addition to shareholder derivative suits and class action suits for board breaches of duty, exclusions from federal plans are exposures faced by health care boards. Federal health care statutes may result in a corporate officer's exclusion from federal programs if a health care entity has been convicted of certain offenses. This may occur even if the individual did not participate in the wrongdoing. (4)
The second component of a fiduciary relationship is loyalty. The duty of loyalty requires a director to put the corporation's interest ahead of their own. Any diversion of corporate assets, opportunities or information for personal gain breaches this duty.
Examples include flagrant diversion, self-dealing, entrenchment, usurping corporate opportunity, excessive executive compensation and insider trading. The issue then becomes when is a self-dealing transaction "fair" to the corporation?
Statues and common law have for the most part overturned a flat prohibition against self-dealing. (4) However, the transaction must be both substantively and procedurally fair.
Substantively, the transaction must meet an arms length market value objective test of value to the corporation. Procedural fairness involves how the board went about approving the transaction. There must be adequate disclosure, with disinterested director approval in order to pass the procedural fairness test.
Remedies for self-dealing include rescission and the awarding of damages. Rescission involves returning the parties to their rightful position prior to the transaction. When this is not feasible, a court may award damages.
Limits of liability
Actions by directors that appear less than judicious in retrospect may be protected from liability by the business judgment rule, state statutes, and insurance and indemnification. The BJR shields both officers and directors from personal liability, as well as board decisions from judicial review. (5)
Justifications for this rule involve encouraging risk taking, avoiding judicial meddling, and encouraging directors to serve. However not all actions are protected by the BJR. In order to gain the protection of the BJR, the transaction in question must be a business decision involving the corporation's lawful business. Other decisions are not protected.
In addition, the decision must be made in good faith and with the best interests of the corporation in mind. (6) Good faith is defined as anything other than bad faith. Bad faith is characterized by most courts by such actions as entrenchment, with-holding material information and abuse of discretion. Also, the transaction in question must be made with due care.
Finally, the directors must be disinterested and independent. This involves the duty of loyalty where there is no personal interest financial or otherwise and no undue influence from others.
Challenges to the BJR involve lack of good faith, lack of a rational business purpose and gross negligence in failing to supervise or be informed. As stated previously, lack of good faith often involves fraud, illegality or conflict. (7)
For example, where a court found that a business plan created strong incentives for employees to commit Medicare and Medicaid fraud, the directors lost the protection of the BJR. (8)
The second challenge involves lack of a rational business purpose. In order to prevail, a plaintiff must show that the decision was removed from the realm of reason or improvident beyond explanation. (9) Needless to say, this is a high bar to meet. (10)
Finally, the BJR may be challenged on the basis of gross negligence in failing to supervise or be informed. State statutes have codified this standard. In summary, courts have been reluctant to hold directors liable for corporate mismanagement; however, less so for inattention to management abuse. (11, 12)
Indemnification and D & O insurance
Health care corporations may offer indemnification to both directors and officers. This is a statutory right granted by the state of incorporation and as such varies in depth and scope. Indemnification is important because the legal costs associated with defense can be astronomical.
Furthermore, state statutes may grant a corporation the power to purchase directors and officers (D & O) policies that further protect the directors and officers. These policies vary widely in terms of coverage but include personal coverage for the director as well as reimbursement coverage for the organization.
As a result of skyrocketing D & O insurance premiums, most states enacted "shielding" statutes that limit a director's personal liability for breaches of duties of care. (13) These statutes usually apply only to directors, leaving officers exposed. The state of incorporation, rather than where the business is operating is the governing law.
The corporation must adopt the relief in its charter or articles of incorporation for the director to obtain statutory protection. The statutes apply only to directors and do not cover areas such as liability resulting from breach of loyalty, or breach of federal statutes such as RICO.
The number of investigations and enforcement actions against health care organizations shows no signs of abating. Federal prosecutors filed 258 criminal actions and 105 civil health care fraud cases in the first half of 2005. HHS excluded 1,695 individuals and entities from participating in the Medicare and Medicaid programs as result of criminal convictions.
The federal government reported more than $17 billion in savings and recoveries from audits, investigations and receivables from health care organizations. (14) It is not surprising that liability often accrues to directors and officers of health care organizations.
A hallmark of a crime is the convergence of an act (actus reus) with mental intent (mens rea). As the reader will discover, officers and directors may be criminally charged when they possessed neither of the above.
Directors and officers may be found criminally liable if they cause the corporation to violate the law in the course of corporate business. (15) Furthermore, the BJR, statutes and D & O insurance do not provide protections for criminal activity unlike shareholder derivative or class action suits.
The key test remains personal participation in the act in question. (16) Personal participation involves commanding, procuring, inducing or aiding and abetting. (17) This can occur expressly or by implication. Personal involvement by implication is a fact-sensitive inquiry but will attach when knowledge of improper conduct is coupled with active concealment. (18)
Board directors and officers may be found guilty even when they did not participate nor even know of the corporate misconduct. (19) This is termed "strict liability," and most often involves crimes involving public health and safety. The most cited cases involve violations of the Food Drug and Cosmetic Act and environmental statutes. (20, 21)
In a case involving mislabeled drugs, the court imposed criminal liability on the board of directors absent their knowledge of the acts in question. The court reasoned that the directors "voluntarily assumed a position of authority in business enterprises whose services and products affect the health and well-being of the public." (22)
In addition, a director cannot be shielded from criminal responsibility for his own act on the ground that it was done in an official capacity as an officer of a corporation. (23) Furthermore an officer or director cannot claim that acts are not his acts merely because they are carried out through the instrumentality of a corporation that he controls and dominates. (24)
The prolonged Disney litigation should remind boards of the consequences of corporate excess. (25) Health care organization boards directors and officers are not immune from civil and criminal liability. While director liability from civil derivative and class action suits may be limited by the BJR, state statutes, indemnification and insurance, the same is not true for criminal liability.
The general rule is that a director is only responsible for acts in which he is a participant. Exceptions abound.
In addition, the Sarbanes-Oxley Act, the single most important piece of legislation affecting corporate governance, exposes health care boards of directors to criminal liability.
Health care boards of directors are advised to remain vigilant for criminal and civil exposure in this ever changing complexity of the intersection of health care, corporate and criminal law.
Christopher Spevak, MD, MPH, MBA, JD is the physician director of government relations for the MidAtlantic Permanente Medical Group and an associate clinical professor of anesthesia at Georgetown University Medical Center. He may reached by email at Christopher.Spevak@kp.org.
Note: This article contains the advice, opinions, statements and views of the author and does not necessarily represent the advice, opinions, statements or views of Georgetown University Medical Center, the Mid-Atlantic Permanente Medical Group, PA or its physicians. The content of this article is provided solely for informational purposes: it is not intended as and does not constitute legal advice. The information contained herein should not be relied upon or used as a substitute for consultation with legal, accounting, tax, career and/or other professional advisors.
1. Del. GCL [section]102(b)(7)
2. In re Caremark International Derivative Litigation, 698 A.2d at 962
3. 42 USC 1320a-7(b)(15)
4. Del. GCL [section]144
5. Cirtron v. Fairchild Camera 569 A.2d 53 (Del. 1989)
6. Smith v. Van Gorkum, 488 A.2d 858 (Del. 1985)
7. Johnson v. Trueblood, 629 F.2d 287 (3d Cir. 1980) cert. denied, 450 us 999 (1981)
8. McCall v. Scott, 239 F.3d 808 (6th Cir. 2001)
9. Michelson v. Duncan, 407 A.2d 121 (Del. 1979)
10. Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985)
12. Barnes v. Andrews, 298 F. 614 (SDNY 1924)
12. Francis v. United Jersey Bank, 432 A.2d 814 (NJ 1981)
13. Del. Code Ann. Tit. 8, [section]102(b)(7)
14. OIG 2005 Semiannual Report http://www.oig.hhs.gov/publications/docs/semiannual/2005/SemiannualSpring05.pdf Accessed August 22, 2005
15. State v. Childers, 187 W. Va. 54, 415 S.E.2d 460 (1992)
16. Commonwealth v. Wood, 637 A.2d 1335 (PA. 1994)
17. 18 U.S.C. [section]2
18. 18 U.S.C. [section]4
19. United States v. Dotterweich, 320 U.S. 277 (1943)
20. 21 U.S.C. [section]352
21. U.S.C. [section]1319(c)(6)
22. United States v. Park, 421 U.S. 658, 673 (1975)
23. U.S. v. Sherpix, Inc., 512 F.2d 1361 (D.C. Cir. 1975); Doubles Ltd. v. Gragson, 91 Nev. 301, 535 P.2d 677 (1975).
24. Bourgeois v. Com., 217 Va. 268, 227 S.E.2d 714 (1976)
25. In re The Walt Disney Company Derivative Litigation, 2003 WL 21267266 (Del. Ch. May 28, 2003).
By Christopher Spevak, MD, MPH, MBA, JD
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|Title Annotation:||Health Law Update|
|Date:||Nov 1, 2005|
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